If you’re like most people who stick to investing in low-cost mutual funds, that’s probably too technical an issue for you to tackle. (And, yes: Facebook is not public so none of us, mortals, could technically do anything but guess how much it’s worth.)

But if you ever plan to dabble in picking individual stocks — and thanks to the growth of online discount brokerages, this is so easy today that many feel compelled to invest in stocks without fully understanding what they’re buying — then knowing how companies are valued can help you make smarter decisions.

The rules

The basic accounting rule tells you that the “net worth” of a company is equal to the net difference between its assets and liabilities. This definition is true in an accounting context, but not in the real-world definition of a company’s liquidation value.

This means that a company’s real worth is what it would sell for in a complete liquidation. All liabilities would be paid off with assets, and the net difference — liquidation value — is the real value of the company.

Under the rules of fundamental analysis, comparisons of value between companies is based on calculating the tangible book value per share. This is the net of assets minus liabilities, further reduced by the book value of intangible assets (such as value assigned to goodwill, covenants, copyrights, trademarks, and patents, for example). These non-physical assets are assigned a value even though they are not tangible. Because their value is subjective, a true company-to-company comparison of value excludes them.

The true liquidation value of a company is somewhere in between the accounting value and tangible book value. It is negotiated. For example, a company with valuable patents or a recognizable brand name and trademark could get millions for selling, even though the value includes intangible assets.

The complexities of accounting standards makes the valuation of companies even more difficult. There is no single method for assigning value to intangibles. This is why fundamental analysts simply remove them from the calculation and divide the net value by the number of shares of stock outstanding:

Tangible book value (per share) is the standard used to judge a stock’s current book value. By itself, it is not a comparative tool, because different companies have different numbers of shares outstanding. However, when you track the book value per share over many years, you can spot a trend. And in fundamental analysis, the trend reveals the direction of “value” — positive or negative, over time.

Tangible book value, even when carefully calculated remains elusive and inaccurate. For example, real estate values are always listed at purchase value minus depreciation, even if its value is far greater today than when it was bought. Liabilities like long-term leases are excluded from the liability side.

So the unfortunate truth is that even when you carefully adjust to remove the intangibles, the resulting “tangible” book value per share only tells you part of the story. A more detailed analysis of all assets and liabilities is needed to find out how much a company is really worth. But remember, the accounting rules leave out more than they include; so you cannot rely on what shows up on the balance sheet to decide what a company is worth. You get a more accurate picture when you compare the current stock price to book value per share.

The P/E ratio (the multiple) tells you the market’s opinion of value, representing the number of years of earnings based on current price. That is the most important measurement of value investors and traders can use.

Can a company be worthless?

A company’s working capital defines its ability to generate cash. This is used to fund current operations (pay bills), give stockholders dividends, and pay for future growth.

But is a company really solvent? The debt ratio can reveal when a company is, in fact, worthless.

The most popular measurement of working capital is called the current ratio. Current assets (cash or assets convertible to cash within 12 months) are divided by current liabilities (debts payable in the next 12 months), and the result should be at ‘1’ or higher in a healthy company. But the current ratio does not tell the whole story.

The debt ratio is the percentage of total capitalization represented by borrowings. A company creates capitalization through equity (stock) and debt (notes and bonds that have to be repaid). So if a company’s total capitalization consists of equal shares of equity and debt, its debt ratio is 50 (or, 50%, because debt is one-half of total capitalization). But what if debt is much higher?

For example, the Hershey Company (HSY) reported the following results for the past five years:

Year

Debt Ratio

2005

40

2006

56

2007

61

2008

81

2009

66

The debt ratio more than doubled between 2005 and 2008, and then retreated in the latest year. However, the trend is ominous. At 66, the debt ratio tells you that for every dollar of total capitalization only 34 cents consists of equity, and 66 cents is borrowed money. The ratio is high and the five-year trend is troubling.

An even worse situation is that of Ford Motors (F). The five-year debt ratio was:

Year

Debt Ratio

2005

83

2006

106

2007

94

2008

112

2009

106

In 2005, total capitalization consisted of 83 cents in borrowings and only 17 cents in equity. But by 2009, the situation was much worse. Total capitalization consisted of $1.06 in debt and $-0.06 in equity. In other words, the liquidation value of Ford at the end of 2009 was negative. Debt exceeded 100% of total capitalization. Some analysts would claim that this is not significant; but the history of General Motors (GM) should be remembered. By the time the company was dissolved and replaced by the federal government’s bailout, its debt ratio was over 200%.

The debt ratio is not only significant in terms of how debt and equity are compared each year, but more so in the trend itself. When you see a company’s debt ratio climbing every year, it means management is relying more and more on borrowed money, meaning future earnings will have to go increasingly to repayments and interest, and less to shareholder dividends or expansion of business. Although the current ratio is a popular test of working capital, it does not tell you when a company is worthless. For example, during the five years when Hershey’s debt ratio increased so much, its current ratio improved every year. Only the debt ratio and its trend can show you when a company’s working capital policies are starting to deteriorate.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: What Is a Company Really Worth? provided by Minyanville.com.